From serious incidents of fraud and mismanagement to underperformance and conflicts of interest- corporate governance in India is at crossroads. With the number of major irregularities that have come to surface in large corporations in the last year, it is time to break the illusions of 'good' corporate and compliance governance practices of Indian companies. Majorly, corporate governance serves as a tool to mitigate conflicts of interest between stakeholders in corporations. These conflicts could appear as a result of diverging needs and wants between management and shareholders or even inter se shareholders. However, a close analysis of the ground reality reveals that the central problem in Indian corporate governance is not a conflict between the management and the owners, but a conflict between the shareholders among themselves. Amidst the storm, the eye of the hurricane has been the debate surrounding related party transactions ('RPT') in India especially in light of the dispute between Rakesh Gangwal and Rahul Bhatia- the promoters of IndiGo, who have been at loggerheads over the latter's unequal powers and the controversial RPT's between Bhatia's private firm- InterGlobe Enterprises ('IGE Group') and IndiGo.
Unfortunately, India's corporate history is full of financial frauds with RPT's being the real cancer plaguing the situation. Ten years after a failed related party transaction unearthed Satyam-Matyas corporate fraud, a pertinent question to ask is- do we have enough checks and balances in place to avoid scams of similar magnitude now? The simple answer is 'no'. Since then, attempts have been made to tighten disclosure requirements, board scrutiny and shareholder approval, but the issue refuses to go away.
In the case of IndiGo, co-promoter Rahul Bhatia's Group set up simulator training facilities with a well-known Canadian company by establishing a private company as a 50:50 joint venture since no such facility was available in India in terms of both quality and capacity. But what explains the Bhatia group leasing/licensing office spaces to IndiGo or providing hotel accommodation to its crew? While it is understandable that IndiGo might have received more 'favourable treatment' from the Bhatia Group as compared to their other customers, why would any private company want to do business on adverse terms? What about all dealings being on arm's length basis to avoid conflicts of interest? Because these RPTs with Bhatia entities were claimed to be 'in the ordinary course of business' at 'arm's length' and not 'material', they've only needed audit committee approval, not board approval or shareholder approval. However, it was revealed that some RPTs were not even approved by the audit committee.
Most recently, the three decade old infrastructure lending Giant, Infrastructure Leasing and Financial Services ('IL&FS') was charged with facilitation of money laundering and repeated dilution of its RPT policy to facilitate sanctioning of loans to related parties which led to huge financial stress for the company. Last year only, Sun Pharmaceuticals Industries Limited was the focus of attention when it came to light that its domestic formulation business was entirely routed through a promoter owned entity called Aditya Medisales. The main issue being the lack of disclosures by the pharmaceutical giant around related party transactions and the lack of governance around it. Another instance is of Dewan Housing and Finance Corporation Ltd. being under the cloud for acting as a vehicle to divert funds and evading reporting of loans extended to related entities.
In many instances, promoters try to escape disclosures by concealing their ownership through a complex network of companies with fast and constant change in shareholding. In other cases, boards try to shield RPT's from approvals by shareholders using defences of 'ordinary course of business' and 'arm's length'. The problem is exacerbated by the power of Audit Committee to grant omnibus approvals. At this juncture, one could take a look into the legal and regulatory framework surrounding RPT's in India.
Related Party Transactions- The Legal Matrix
A related party transaction is an arrangement between two entities which share a preexisting relationship. Section 2(76) of the Companies Act, 2013 ("the Act"), defines a related party with reference to a company, to mean- a) director or a KMP or their relatives or b) a firm, private company in which the partner/director/manager or his relative is a partner or c) a private company/a public company in which a director/manager is a director and holds along with his relatives, more than 2% of its paid-up share capital, amongst other inclusions. Section 188 of the Act lists out few specified related party transactions such as sale, purchase or supply of goods or materials, selling, buying or leasing of property of any kind and availing or rendering of any services, amongst other things. While there is an exemption notification in place, that completely exempts private companies from RPT's, public listed companies are governed not only by the Act but also SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 ("Listing Regulations"). However, public unlisted companies are only governed by the Act.
The Act exempts any transactions entered into by the company in its ordinary course of business other than transactions which are not on an arm's length basis from the approval of both the Board and the shareholders. However, the Listing Regulations do not provide for any exemptions to any transaction.
As per the Act-
- Audit Committee approval is required for all RPT's.
- All RPT's which are not in the ordinary course of business and/or on arm's length basis require Board approval.
- All RPT's which are not in the ordinary course of business and/or on arm's length basis require shareholders' approval when exceeding the specified limits provided in the Companies (Meetings of the Board and its Powers) Rules, 2014.
As per the Listing Regulations, all 'material' RPT's require approval of the shareholders, irrespective of the fact whether the transactions entered into by the company are in the ordinary course of business and/or on an arm's length basis. The Listing Regulations prescribe a common threshold i.e. 10% of annual consolidated turnover for transactions to be termed as 'material'.
ARA LAW VIEWS
It is imperative for the Government to understand the lapses in the law and take appropriate measures to address the same so as to ensure the maintenance of strict corporate governance standards and protection of interests of all the shareholders. Some of the suggestions in this respect are as follows:
Proper checks and balances at the Board level
The Act provides that if the transaction is done in the 'ordinary course of business' and is on an 'arm's length basis', then the company need not seek board approval. However, the most important question is, if not the Board, then who'll make the determination that a particular transaction between two related parties is being conducted as if they were unrelated. Many a times, even the board approval of these transactions takes places hastily with no proper examination and ascertainment of the terms of the transaction. So, proper checks and balances need to be placed at board level to ensure proper exercise of the company's/board's discretion.
Guidelines for determination of 'arm's length'
Section 188 of the Act defines 'arm's length' to mean 'a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest'. However, there is no objective criteria to determine the same.
Lower thresholds for shareholders' approval
The financial threshold for determination of 'materiality' of an RPT as per Regulation 23 of the Listing Regulations is quite high. A transaction is considered 'material' if the transaction to be entered into individually or taken together with previous transactions during a financial year, exceeds 10% of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity. Because only 'material' RPT's require the approval of the shareholders, this threshold of 10 % is way too high which leads to a large number of RPT's falling outside the purview of this approval requirement. Similarly, the thresholds prescribed by MCA for mandatory approval by shareholders is quite high.
Introduction of special resolution for certain specified categories
It may also need to be considered introducing special resolutions at both the Board and the shareholders level to eliminate the possibility of any objection by the minority shareholders at a later stage.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.